FLASHBACK | The Bear Case on $BABA: What The Street Is Missing

Takeaway:China’s Elite drives BABA’s GMV. BABA's user growth moving forward will come from a much weaker consumer; a double-edged sword for its GMV.

Editor's note: Hedgeye Internet & Media analyst Hesham Shabaan has basically been the only bear on Alibaba and has been highlighting the major risks to the BABA story since 10/21/14. Since then, we've witnessed the validation of his bearish thesis within BABA’s quarterly earnings with the emergence of a new concerning trend that landed BABA on our Best Ideas list as a Short on February 11. We are hosting a special call outlining the bear case on BABA this Thursday March 5th at 1pm. Ping sales@hedgeye.com for full access. The note below was originally published on November 26, 2014.

INTRODUCTION

We hosted a call last week laying out our BEAR case on BABA, and the key metric we're tracking to time the short opportunity (contact us for the deck and replay). We're going to publish a series of short notes detailing the salient points from the call. This is the first, and maybe the most important.

KEY POINTS

CHINA’S ELITE DRIVES BABA’S GMV: Both GMV/Active Buyer (average spend) and its cohort commentary suggest China’s upper class drives its GMV. After comparing these metrics to China consumer demographic data, there is no other plausible explanation.

GROWTH WILL COME AT A PRICE: New BABA consumers will have considerably less funds to spend. In turn, user growth will pressure BABA’s average GMV; turning what was a growth driver into a headwind, and leading to a sharp deceleration in GMV growth through F2017. Note that ~85% of BABA’s revenues are linked to its GMV.

CHINA’S ELITE DRIVES BABA’S GMV

The average consumer on BABA’s China Retail sites spends roughly ¥6.5K annually (~USD $1.1K). In the chart below, you can see the distribution of China’s internet users by income (red columns) and what BABA's average GMV would represent as percentage of their incomes (orange columns). In short, BABA’s GMV would be a prohibitively large amount for most consumers in China; especially since BABA can’t sell’s everything.

The other thing to consider is BABA’s cohort commentary on its F2Q15 earnings call, which we have pasted below.

BABA F2Q15 Earnings Call (Maggie Wu): “Let me share with you some color on this average spending per buyer. As I said that the longer customers stay with us, the more they're going to spend annually on our platform. I'll give you an example”

“The customer who stayed with us for a year's time, their average annual spending level is somewhere around RMB 1,000”

“And for the ones who stayed with us for five years' time, their spending level is somewhere around RMB 15,000”

“And then for the ones who stayed around 10 years, their levels is going to above RMB 30,000”

The amounts spent by those on the platform for more than 5 years are just jaw-dropping when you consider the income distribution of China’s internet users. If we compare these metrics to the first chart above, only 5% to 14% of China's internet population at most could afford to spend ¥15K-¥30K annually; let alone BABA's ¥6.5K average GMV.

GROWTH WILL COME AT A PRICE

The obvious takeaway is that BABA’s GMV is currently hostage to the whims of its upper class consumers. What’s more concerning is that GMV growth moving forward will be driven primarily by new consumers with considerably less to spend. In turn, new user growth will come with disproportionately lower GMV growth since average GMV is facing decline; turning what was a growth driver into a headwind.

We illustrate this dynamic in our China GMV Market Model, which is driven by user growth and e-commerce spending projections (both by income cohort); the former being the more important driver. As new lower-income consumers join the BABA platform, they will grow in proportion to BABA’s total users; driving down both average income and average spending of its user base.

Note that roughly 85% of BABA’s revenues are linked to its GMV, which our model suggests is heading for sharply decelerating growth through F2017.

We will be publishing a follow-up note with more detail on the impact of our GMV projections on BABA's business model. In the interim, see link below for broader summary of our bearish thesis, or let us know if you would like to see our BABA deck.

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KATE: A 2-Yr Double, Again

Takeaway:We think numbers are still too low, and that 2015 will be a break-out year for KATE. There’s a clear roadmap to a $75 stock. 2-yr double.

Though most key metrics were already reported, this was a stellar quarter for KATE – marked by a) 28% comps (a 600bp sequential acceleration on the 2-yr), b) 31% growth in global store growth, c) 50%+ growth in e-commerce (2x+ acceleration from 3Q), d) a 21.2% EBITDA margin, closing (negative return), e) six new licensing agreements, and f) swift execution on the closure of Jack Spade and Kate Saturday. And all of this was in its seasonally most important quarter. This model is primed and loaded to have a fantastic 2015.

We’re Above Consensus. That said, we think that management was being overly cautious with its targets for 2015. There are so many levers in this model, and our sense is that the company downplayed them. KATE guided to $185mm-$200mm in EBITDA for the year – assuming the top end of revenue guidance, that’s 15.7%, or about flat on a year/year basis. But we’re modeling $237mm, or about 110bp higher than last year. That’s about 65% EBITDA growth for the year, a number we expect to moderate only slightly to 50% the year after.

Quite frankly, we like the company’s conservatism, as it will keep expectations grounded, and mitigate the liklihood of an earnings day sell-off, which happens too often for KATE to call it a coincidence.

What’s It Worth? So that begs the question as to what we should pay for KATE. By the end of this year, we’ll be eyeing about $345mm in EBITDA and $1.30 in EPS. When looking at the 50% and 100% growth rates in EBITDA and EPS, respectively, we could definitely argue a big multiple. On the flip side, this is a fashion business, and there will almost certainly be a time (like KORS is experiencing now) where it will see multiple compression as it matures. But keep in mind that KORS has a brand footprint of $6.4bn and EBIT margins of 30%. KATE has a $1.4bn footprint (smaller that Tory Burch at $1.9bn) and margins of only 11%. It will be a long time before we have to ask the ‘is it over’ question. Until then, we think the multiple will continue to defy gravity in the eyes of anyone that’s not a growth investor.

For argument’s sake, let’s keep the forward multiples in place that KATE has today – 50x earnings and 19x EBITDA. We think that there’s upside this year as the company beats. But on 2016 numbers we’re looking at 50x $1.32 = $66, or 19x EBITDA in the mid 50s. Roll ‘em to ’17 and you get to over $2+ in earnings power, or around a $75 stock.

Here’s A Few Things That Were New To Us on The Call Today

License Agreements

- KATE announced 4 new home license agreements to the portfolio today. That gives them 6 on the year in mostly focused in the home/tableware department, but the one we think presents the biggest opportunity is on the watch front with FOSL.

- The way the math works, it’s good for $0.02-$0.03 in year 1, a nickel in year 2, and $0.10 in year 3.

Store openings

- The company guided to 50-55 new KSNY stores for the year. Net out the Saturday and Jack Spade closures for the year and it equates to 24 new openings for the year.

- It’s important to remember that these stores are not create equally. We think it’s generous to assume that KSS and Jack operate at 50% of the unit productivity of the flagship banner. Sales per average unit for the year were $4.5mm, meaning the combination of Saturday and Jack were in the $3mm ballpark while KSNY was producing at $4.7mm per box.

- Not only that, but if we assume that the average Jack/Saturday box was plugging along at $3mm per unit, that means it was a $91mm retail operation with an operating loss of 21mm for the year. That’s a -23% EBIT margin.

Gross Margins

- There was a lot of convoluted talk on the call around gross margins that we have to admit we had to read 3 times just to understand what the heck George was talking about. Here is our summary in plain English.

- Inventory liquidations in the Saturday/Jack brands equated to a $14.4mm hit in gross margin. That’s 126bps of the 210bps erosion during the year. Then you have to factor in the fact that the two sister brands were operating at a gross margin about 1000bps+ below KSNY. That tells us Kate Spade proper was humming along at a 62% gross margin clip – we don’t think that Fx (which is 80% hedged) or a few new outlet doors will offset that.

EBIT/EBITDA Margins

- Consolidated EBITDA margins ended the year at 12.6%. Up 200bps YY. The combination of Jack Spade and Kate Spade Saturday ate away 310bps in EBITDA margin. $6.4 from the 2Q14 inventory liquidation and another $29mm in 4Q.

Brian McGough

Alec Richards

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03/03/15 01:09 PM EST

CRUISE PRICING SURVEY FEB 2015

With oil prices no longer an EPS tailwind - bunker fuel gained 15% in February MoM - yields have to deliver. Our latest pricing survey uncovered mixed results, both from a market and company perspective. Following the slowdown in our January pricing survey, pricing pivoted favorably, in part to one of the coldest February’s on record in North America. CCL in particular seems to have improved. However, Europe pricing moved lower again. RCL pricing in this market was disappointing and we remain most cautious on the name.

Hedgeye's Healthcare Sector Head Tom Tobin and Analyst Andrew Freedman will answer your questions on athenahealth (ATHN) and Hologic (HOLX) and more in this free and interactive Q&A event at 12:30PM ET today. Post your questions in the chat box below the video.

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